Deflationary traps, agents’ beliefs and fiscal–monetary policies

Abstract We study the role of agents’ limited cognitive capabilities, combined with fiscal and monetary policies, in the generation of a deflationary trap. In order to do so, we employ a heterogeneous expectations New Keynesian model in which the agents’ forecasts are based on simple heuristics. Thanks to a learning mechanism, the model is able to generate endogenous changes in agents’ beliefs that we prove to have a crucial role in the characterization of a deflationary trap. We show that the probability of hitting the zero lower bound on the interest rate, and potentially entering a deflationary trap, is not only affected by the inflation target set by the central bank. This probability is also influenced by the governments’ focus on public debt stabilization and by the agents’ memory and willingness to learn. We also show that the impact of these factors is very significant for inflation targets in the range 0–3%, while an inflation target of $$4\%$$ <mml:math xmlns:mml="http://www.w3.org/1998/Math/MathML"> <mml:mrow> <mml:mn>4</mml:mn> <mml:mo>%</mml:mo> </mml:mrow> </mml:math> isolates the system from the zero lower bound problem.